Streaming video services get creative

Online entertainment provider Netflix Inc. this month released the first episode of its originally produced political drama “House of Cards,” available for free for one month to all consumers in the 40 countries where the Netflix streaming video service is available, the company says. The rest of the 13-episode season, which stars Kevin Spacey as a ruthless, power-obsessed congressman from South Carolina, is available to subscribers who pay $7.99 per month for unlimited access to Netflix content. Netflix released the entire season Feb. 1.

The show’s release is the latest in a series of moves by Netflix and its Internet rivals Amazon.com Inc. and Hulu to produce their own original shows, providing exclusive access to content without negotiating costly licensing agreements with TV networks and movie studios. However, analysts have mixed opinions on whether that strategy will draw enough new subscribers to these services to make them worth the investment.

“It's early for us on the proprietary original content,” Netflix CEO Reed Hastings said in the company’s last quarterly earningscall with investors. “We're staying flexible, learning and we'll grow into original program[ing] step-by-step.”

Last year, Netflix’s content costs grew from 22% of revenue to 44% of revenue ($704 million to $1.588 billion), according to Ed Liston, CEO at financial analysis and reporting company StockRiters. Despite expansions in the United Kingdom and Nordic regions, Netflix gained only about 5 million new subscribers last year, Liston says.

“To capture a higher market share and grow rapidly in the international arena, Netflix needs to develop high-quality content,” Liston says. “While investing heavily in content quality is a prerequisite for international markets, it could only break even with the content cost if the subscriber base grows large enough. Going forward, high content costs may incur losses in 2013.”

In the last quarter of 2012, Netflix reported it had 27.1 million U.S. subscribers and 33.3 million subscribers globally. In the same quarter, Hulu reported more than 3 million U.S. subscribers. Amazon does not report the number of its Instant Video subscribers. But Scot Wingo, CEO of e-commerce services provider ChannelAdvisor Corp., which helps retailers sell on such online marketplaces as Amazon and eBay, puts the number of its Prime members at 18 million, and those members get access to Amazon’s Instant Video at no extra charge.

Amazon streams TV shows and movies to customers via Amazon Instant Video and via its Lovefilm subsidiary for U.K. and German customers. Hulu provides videos for free with advertising during and between videos, or for $7.99 per month for Hulu Plus members, who see limited advertising only between videos, it says.

In addition to “House of Cards,” Netflix last year released an original comedy about an ex-gangster who enters the witness protection program, called “Lilyhammer.” This April, it will release an original horror series, “Hemlock Grove,” and, later this year, a new season of the comedy “Arrested Development,” which originally aired on the Fox TV network. The online retailer also plans to release this year two comedy-drama series: “Derek,” from comedian Ricky Gervais, and “Orange is the New Black,” based on a woman’s memoir of time spent in prison. In production without a definitive timeframe, Netflix is also working on an original kids’ series with DreamWorks Animation SKG Inc., it says.

Netflix may have a leg up on competitors in how it creates original content, because it leverages its vast store of customer information to figure out what kind of shows will appeal to viewers, says Jake Mann, another analyst and editor at trading news site InsiderMonkey LLC.

“In the past, the company's system has given it the ability to accurately determine which third-party content maximizes viewership,” he says. “Already an advantage over its traditional TV-based peers, Netflix's new focus on original programming makes even better use of this information, allowing it to decide which actors and themes are most likely to succeed at any given time.”

Meanwhile, Amazon says it has 11 pilot TV shows in production. Six are comedies, which have already begun filming, and five are shows aimed at preschoolers; Amazon did not reveal when filming begins for those shows. It says it will determine which pilots to develop into full series based on viewer feedback.

Unlike Netflix, Amazon invites the public to pitch movies or TV shows of any genre and budget to its production house, Amazon Studios, via its web site. Online it lists 26 TV shows and 23 movies in development as potential programs, for which it has paid each writer $10,000, Amazon says. If it turns a pilot TV show into series, Amazon will pay the writer $55,000 and 5% of sales from merchandise connected to the series, like toys or shirts, according to Amazon Studios. If it develops one of the movies, it says it will pay $200,000 to the writer and another $400,000 if the film generates $60 million or more at the U.S. box office. Amazon has a deal to give Warner Bros. Pictures a first look at top Amazon Studio projects for theatrical development, it says.

Hulu, while smaller than both Netflix and Amazon in terms of annual revenue—it reported revenue of $695 million in 2012 versus $3.61 billion for Netflix and $61.09 billion for Amazon—is also revving up its own original content production. This year it will launch three new original series: an animated comedy series for adults, a drama and a documentary about sports mascots, it says. That follows the launch of four other original series the company produced and released in 2011 and 2012.

Producing a TV show costs $1.5 million to $2 million on average per episode, though premium networks like Home Box Office might pay much more, says Dan Rayburn, executive vice president of news service StreamingMedia.com and a principal analyst at Frost & Sullivan. He and other analysts report that Netflix spent at least $100 million to produce the first two seasons of “House of Cards;” Netflix declined to comment on that estimate.

That price tag might prove unsustainable, as even offsetting it with a significant gain in subscribers is unlikely, Rayburn says. “What happens once you go through all the episodes? How many original series can they produce at $100 million each?” he says. “They’d like to make more, but they can’t get enough new subscribers to cover that cost.”

In 2012, Netflix reported it had committed more than $5.6 billion to acquire streaming content, including $3.2 billion in obligations beyond 2012. Amazon, on the other hand, only reports future costs for acquiring and licensing outside content of $723 million, spread through 2013-2017.

Amazon Instant Video lists 70,251 movies and TV shows available to stream and Hulu says it offers 70,850 movies and TV shows between Hulu and Hulu Plus, accounting for 54,000 total hours of programming. A single licensing deal Hulu made with CBS last year added more than 2,600 episodes of that network’s TV shows to its library, it says.

Netflix does not reveal the exact size of its digital library, but the retailer’s annual letter to investors boasted that its offerings dwarfed those of its competitors. In the letter, Netflix presented how many of the top 200 most popular movies and TV shows in its library appeared in Amazon Prime, Hulu Plus and Redbox Instant, a newer startup competitor stemming from the Redbox kiosk-based DVD rental service. “Of these 200, 113 are not on Amazon Prime, Hulu Plus or Redbox Instant,” Netflix writes. “Of the 87 that are available on at least one of these services, Hulu Plus offers 27 of the 200; Amazon Prime 73 of the200; and Redbox Instant 12 of the 200, with significant overlap in TV between Hulu Plus and Amazon Prime, and in movies between Amazon Prime and Redbox Instant.”

Despite high costs compared to licensing agreements, there is, nonetheless, an argument for heavily investing in an original show like “House of Cards.” “Content can constitute a powerful differentiator if Netflix or Amazon.com can come up with a huge hit that’s only available in its system, whereas much of the licensed content can be available elsewhere,” says Paulo Santos, an independent analyst and founder of finance web site Thinkfn.com. But he adds that keeping an original hit exclusive also makes it more expensive, as a retailer won’t earn money from deals to stream those shows via other providers.

Amazon’s goal might be to lure customers into its Prime program, Santos says, which could appeal to consumers as a cheaper alternative to Netflix, at $79 per year for Amazon Prime versus roughly $96 per year for Netflix’s streaming video service. That’s in addition to Prime’s other benefits, notably free two-day shipping on all Amazon orders. But, while Santos concedes that Amazon may be in a position to gain some extra sales from new Prime members, he cautions that those members won’t necessarily buy significantly more than other customers.

Originally, customers self-selected to sign up for Prime because they knew they’d buy enough earn back the annual fee in saved shipping costs, Santos says. “This led to statistics saying that Prime members bought much more often than non-Prime members,” he says, but in reality that data is biased, since customers who bought more were the ones who tended to sign up so they’d save on shipping. “Knowing this, it’s not likely that Prime members getting Prime because of streaming will increase their buying a lot—but they might increase it some,” he says. With the retailer’s history of aggressive pricing, including adding Instant Video as a free service with Prime membership, he isn’t convinced that it will pick up enough new Prime members to justify the cost of producing original content.

“If we know Amazon, I’d say that at some point it will try to compete harder on price, even accepting more losses,” he says. “The most probable result at this point, however, is for [original content] to produce losses for the whole company.”

Rayburn of Frost & Sullivan disagrees. He says that Amazon can potentially make up for some production losses in other parts of its business, not just through extra shopping from Prime members. For example, Amazon has more ways to make money on the same digital content than Netflix. It not only offers TV shows and movies via instant streaming and as rentals, like Netflix, but Amazon customers can purchase hard copies or downloads of many titles, too. Additionally, Amazon sells hardware used to stream Internet videos, such as computers or gaming systems, including its own line of Kindle tablets. The retailer also hosts its digital library on its own network of servers, Amazon Web Services, thereby reducing the costs of offering that content to customers compared to what Netflix pays for hosting its library on the same network.

“Amazon is the winner in the long run because they own many parts of the industry,” Rayburn says. Those parts may be the technology and content related to Amazon Instant Video, or they may be among the retailer’s many other business offerings, such as general merchandise or marketplace sales, he says. “Amazon has tons of business models. Netflix has one.”